Things that make you go hmmmmmmm...

Does anybody find it ironic that the Federal Reserve hired Michael Alix, the former Chief Risk Officer from the now-defunct Bear Stearns, to manage the Fed's risk profile? What on earth did he do right to manage Bear Stearn's risk--considering they were insolvent? I guess on Wall Street at least, losing money is a badge of honor and gets you fast-tracked into a top position within the government.

Also, what makes former investment bankers selling collateralized debt obligations (mortgage-backed securities) and credit default swaps competent fund managers? Many are out on the streets, and are now starting hedge funds, charging 2/20, I'm sure. It's astounding...fool me once, shame on you...fool me twice, shame on me...

Bailout or No Bailout?

I'm from the school of let 'em die. If you and I make poor investment decisions, we have to suffer the consequences. These executives applied far too much leverage, took on way too much risk, and after plundering their firms, they get golden parachutes. Where's the accountability factor?

I'm all for the founders of Google earnings billions because they have created a lot of value for consumers, business, shareholders, and employees. But when executives run their firms to the ground, they should not profit from said disasters, whether their firms get bailed out or not. A meritocracy rewards those who add value, not those who detract from it.

As much as I hate that the taxpayers bear the brunt of rescuing an AIG, I reluctantly agree they should probably be bailed out, because if they implode, the cascading illiquidity would essentially freeze up markets worldwide, as the sovereign funds, hedge funds, pension funds, mutual funds, private equity firms, and every financial institution would suffer a loss of confidence in the US financial markets, which would bring about a dark age analogous to the Great Depression. No one wins in that scenario, save the few bottom fishers with cash and balls to step up and play in the deep end of the pool.

But make no mistake: the intended recipients of these bail outs are the big institutions--not necessarily the common man, altho we all are in the same boat.

Having said that, there is a downside to this massive injection of liquidty--re-inflation. Interest rates should be favorable short-term, but when oil approaches $150 a barrel, when gold flirts with $1500/oz, the Fed will have no choice but to raise rates. Again, the lesser of two evils, but still an evil...Eventually, the economic shocks worldwide and the domestic slowdown will eventually dampen demand and cost of living increases, but until then, gold seems more stable than the US Dollar.

You know the world is turned upside down when there is more concern about the USD than the Brazilian currency, Russia has a flat tax, and the US has the 2nd highest tax brackets in the western world. Our leaders have forgotten what has made this country (and California) great.

401K, IRA--or not?

1) 401K's are good, but not great. If the company matches your contribution, that's a good thing, but I would not contribute more than that.

2) The reason why a 401K is merely good is due to its deferred tax status. You get a small tax break during the contribution phase, but you get clobbered with income taxes during your harvest years.

3) Roth IRA's are better than a standard IRA, but a Roth comes with restrictions and most high-income individuals don't qualify. So it's better than good, but it is not best (the tax-free harvest makes it better than a regular IRA).

4) Indexed funds are better than MOST managed funds, but there are hidden costs when indices get re-balanced. It's still better than most managed funds due to lower fees and better performance. Better yet, there are vehicles linked to the indices, but not investments IN the indices. Hence, they also provide downside protection. This is huge. And oh, btw, they also allow tax-favored accumulation and access.

5) Perhaps small cap funds have outperformed large cap funds, but that depends on the time window, and small caps are historically more volatile. That is not a good fit for older investors. Most of my clients aren't 25, because most 25 year olds have no assets.

6) Risk is a relative value, and there are efficient ways for diversification and risk mitigation.

7) Dollar cost averaging only works if there is a general uptrend or steady state. If you had dollar cost averaged into the Great Depression, you would have had to wait until the mid 1950's to get back to even. If you had dollar cost averaged into the tech bust, you may never get back to even.

8) There are many geniuses who are financially misguided. The first thing I would ask a finance professor is how much is their net worth and how did they achieve it.

9) I advise people to contribute to a 401K only to the level the company matches, as they are basically paying for the taxes you will owe during the distribution phase (retirement). Deferring taxes only means postponing taxable events when your portfolio will be worth more--the government set it up so that they get to take a bigger slice of your accumulated values. In this scenario, a typical American worker gets a $60,000 tax break during their contribution phase, and gets taxed $800,000 during the distribution phase (retirement). And if their estate plan is poorly structured, their non-spousal heirs get taxed another 72% upon death. That is, of course, unless they die exactly in the year 2010. After 2010, the exemptions from estate taxes revert back to pre-2001 levels.

There are a select few who stack the odds in their favor, looking for high reward/risk opportunities.

The younger you are (or the more you earn), the bigger the potential mistake. Think about it--compounding is great if it works in your favor. When it works against you, it is crushing.

Today's entry, a year later...

Today's entry:

I've never made money following the crowds. I've always made money going against the masses. If I were to hire someone to manage my money, I'd rather them have a background in crowd psychology and mob theory, instead of degrees in econometrics. People tend to rely too much on numbers on things not necessarily controlled by numbers. It works for designing innovative technology; it does not work for predicting behavioral finance. In other words, when they win, it's because of their savviness and acumen, and when they lose, it's due to bad luck. It is analogous to a reknown physicist claiming he will find the next treatment for certain types of cancer, using stem cell research. The interviewer decried his attempts, asking how a physicist could solve a problem that was clearly a medical and a biotech one. He curtly replied that biologists and people who study medicine don't know numbers. Metastasis is a compounding problem, an uncontrollable geometric growth of malignant cells. The drug discovery process itself is a numbers game. He was spot on in his approach. OTOH, behavioral finance is more behavioral than economic models, and mere numbers. Market participants are human, not drones who predictably turn like electrons. I've had very long and interesting discussions with some of the brightest minds on and off Wall Street, and many of them think the number-crunchers are deluding themselves into thinking they can outsmart markets. And the road kill of some very smart people only confirms my suspicions. It's like a casino: the players keep playing as long as they win, but as soon as they lose, they get washed out for the next group of gold speculators to arrive. The key is to manage OPM, as the managers make money no matter what their performance is, and they last as long as they can get away with it (underperformance). The clients underperform the index averages 80% of the time. And the top 10% managers are so good that they can outlast their peers, and make a killing over their life times. I've reached a stage where my clients and I can't afford to take a hit like the tech bubble, and the recent subprime mortgage crisis. It's about capital preservation, efficient (i.e. low-cost) diversification, risk mitigation, asset optimization (all assets, not just investable liquid assets), and guaranteed floors (the last two are why I win). Lots of people can claim the first 3, but few can deliver the last 2.